Market Place; S.E.C.'s Analysis Of Nov. 15 Plunge

By Floyd Norris

Published: January 9, 1992

THE Securities and Exchange Commission, in a preliminary report, has concluded that varieties of program trading played a large role in the abrupt decline of the stock market on Nov. 15, when the Dow Jones industrial average fell 120 points. The report said a number of Wall Street firms, which were not identified, had in essence bet on higher stock prices, and were forced to scramble for cover when prices began to fall.

In effect, the report pointed the finger at a strategy similar to portfolio insurance, which was a leading factor in worsening the Oct. 19, 1987, market crash, when the Dow fell 508 points.

It also emphasized the role played by the expiration of stock-index futures and options on Nov. 15, and seemed likely to renew moves for changes in the way such expirations are handled.

The report was released yesterday by Representative Edward J. Markey, Democrat of Massachusetts, the chairman of the Subcommittee on Telecommunications and Finance, who said it indicated the abrupt fall was "largely the result of internal market dynamics and long-term investment outlooks, not Wall Street's fears about possible cuts in credit-card interest rates."

In November, a Senate vote aimed at forcing banks to cut credit card rates was widely cited as having been a partial cause of the collapse.

The evidence produced by the S.E.C. report, written by William H. Heyman, the director of the S.E.C.'s division of market regulation, indicated that a variety of factors caused the price decline, once it began, to accelerate. But it did not answer the question of what, if anything, initially caused the market to turn lower. In that respect, it did not dismiss concerns over credit-card legislation, a sharp fall in biotechnology stocks that began that morning, or any other factor that could be cited.

"It's very difficult to determine what kicked it off," Mr. Heyman said in an interview. "That does not really emerge from a mere audit trail of transactions. One would have to interview participants."

In the report, the S.E.C. said, "it appears likely that the market decline on Nov. 15, 1991, had more to do with institutional investment outlooks, concerns over protecting year-to-date market gains and intermarket dynamics than any single 'triggering' news event."

The principal new evidence concerned the activity of unidentified Wall Street firms, which had written options to protect institutional investors against sharp declines in the values of their stock portfolios. For the institutions, such options constituted a form of portfolio insurance. In effect, the institutions had paid a fee to the Wall Street firms to assure that they would not be badly hurt by falling prices.

But those firms had not fully hedged their own positions, meaning they had effectively bet against rapidly falling prices. As a result, the S.E.C. report indicated, the firms had to scramble to cover their own exposure, using stock-index futures and options in "dynamic hedging" strategies, to use the jargon. Effectively, such actions amount to selling stocks and put similar pressure on the market.

In 1987, the primary form of portfolio insurance involved institutions selling stock-index futures as prices declined. While the form was different this time, the result was similar. The S.E.C. report gave no information on the amount of such activity, and said more information was needed to assess its importance.

The Nov. 15, 1991, drop in stock prices proved to be a relatively short-lived one. After dropping 120.31 points on that day, closing at 2,943.20, the average recovered 29.52 points in the following session. It then began to slip again, but rallied in mid-December and had made up the entire loss by Dec. 23. It has since risen to 3,203.94.

It was clear on Nov. 15 that the expiration of stock-index futures and options had played a role in the fall in prices. When such contracts expire, on the third Friday of each month, the value of the expiring contracts is based on the closing price of each stock in the index. Index arbitragers, a type of program trader, will often buy or sell stocks at the close to lock in profits from expiring contracts.

On Nov. 15, there were substantial selling orders for stocks, related to the expiration, helping to drive prices lower. At the time, a trader estimated that such selling cut 20 or 30 points from the Dow, but the S.E.C. does not attempt to quantify the impact.

The S.E.C. has long believed that volatility can be reduced if such contract expirations are based on opening, not closing, prices, as is done with some contracts other than the ones that expired in November. The argument is that there would be less time pressure to find buyers to offset such program-generated sell orders. The S.E.C.'s chairman, Richard Breeden, in a letter to Mr. Markey, said the commission had again asked exchanges to "submit detailed reports" on the issue.

Duke Chapman, the chairman of the Chicago Board Options Exchange, which has resisted such a move, said yesterday that many brokerage firms believed that individual investors who trade such options could be badly hurt by moving to morning expirations, particularly if overnight news caused prices to fall sharply. He added that his exchange believed the "market-on-close" sell orders played only a minor role in the Nov. 15 plunge.